It seems pretty clear that after many years of below-normal levels, interest rates are about to start climbing. What does this mean for my investments and for my finances in general?

—A Reader

Dear Reader,

Predicting when the Federal Reserve will begin raising interest rates seems to be a top focus of economic forecasters these days. And for good reason. The Federal funds rate—the interest rate that banks charge each other to borrow Federal funds overnight—has been effectively at zero percent since 2008, so any rate increase is big news.

But why should the average consumer care what interest rate banks charge each other? Because that same interest rate is used to determine a variety of other short-term rates that touch us all in our daily finances such as interest on bank deposits, loans, credit cards and adjustable rate mortgages. And it will ultimately have an effect on both the bond and stock markets.

Overall, the fact that the Fed is considering raising rates is a good thing because it means the economy is doing well. However it will have a different impact on different people. In general, an increase in rates is good for savers and bad for borrowers. For investors, it's more of a mixed bag depending on the types of investments you hold.

The current prediction is that the Fed will begin to raise rates this fall or winter. However, it's also predicted that any rate increase will be slow and gradual rather than dramatic. There's no need for consumers and individual investors to panic, but it's a good idea to know what to expect and what changes you may want to make in your own financial strategy.

Impact on bond investors

When interest rates rise, bond values decrease. However, the impact will vary depending on your circumstances. Here are three possible scenarios courtesy of my colleague at Schwab, Kathy Jones:

If you've been on the sidelines waiting for interest rates to rise, around the time the Fed begins to raise interest rates you might consider investing in intermediate-term bonds or bond funds that mature in five-to-ten years to boost income in your portfolio. You might also consider building a bond ladder by buying individual bonds or bond funds with different maturities. Bond ladders work because they give you the flexibility to make changes as interest rates change.

If you're currently invested in long-term bonds, this could be a good time to add some short-term bonds or cash to add balance and reduce volatility.

If you're already invested in intermediate-term bonds or already have a bond ladder, you may not need to make changes. But again, you could consider adding some short-term bonds or cash to reduce potential volatility as rates change.

Impact on stock investors

Generally speaking, interest rate hikes depress stock prices. That usually also means more market ups and downs. The good news is that, because of all the speculation on when and by how much rates will rise, it’s likely already somewhat built into stock prices. So a rate increase may not have that big of an impact.

As always, keeping a long-term view is important and diversification is king. But if you are looking to invest, focus on companies that have a strong balance sheet, meaning they have good reserves and less need to borrow. Also, an uptick in interest rates will likely mean different things for different sectors. For example, financial companies may do well because rising interest rates can increase their margin, or the difference between what they charge for lending versus what they pay on deposits.

Impact on all of us

When it comes to the rest of your financial life, there may be cause to celebrate as well as areas to proceed with extra caution. If you're a saver, you can look forward to eventual better returns on your money in savings accounts. Short-term CD rates should also begin to go up. That can be especially good news for retirees who have been struggling with near zero returns on their cash.

However, borrowers need to beware. Mortgage rates will rise, which is significant if you're applying for a new home loan or have a variable-rate mortgage. This could hit first-time buyers especially hard. Consider that a one percent interest rate increase can increase the cost of a $100,000 mortgage by over $700 a year. HELOC rates will start to inch up. Other loans also will be more expensive, so whether you're financing a new car or carrying a balance on your credit card, it's going to cost more.

Interestingly, rising interest rates may also lead to a decline in home prices (unless you're in a particularly hot real estate area), so sellers will want to factor that into their plans. And, as borrowing costs go up, people tend to buy less, which affects businesses in general.

Keeping a balanced perspective

No doubt there's a lot to be aware of, but it's also important not to over react. It's easy to be swayed by the constant hype and never-ending media speculation, but if you keep on top of your own financial situation, stay diversified and true to your goals, and carefully consider your borrowing needs, you should be able to lessen any negative impact of a rise in interest rates and perhaps turn it to your advantage.

Important Disclosures

Diversification cannot ensure a profit or eliminate the risk of investment losses.

(0715-4951)

The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.

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